Justin Muzinich — Find Good Businesses

Winter 2014

Justin Muzinich is a President at Muzinich and Co. Inc., a pri- vately owned investment management firm with a focus on rigorous credit analysis. Prior to joining Muzinich, he was a Managing Director at EMS Capital and worked in the mergers and acquisitions group at Morgan Stanley. Mr. Muzinich holds a Juris Doctor degree from Yale Law School, where he was an Olin Fellow in Law, Economics and Public Policy, and an MBA from Harvard Business School, from which he graduated with highest honors as a Baker Scholar.

Graham & Doddsville (G&D): Can you tell us a little bit about your back- ground and how you got interested in investing?

Justin Muzinich (JM): Sure, I’ve always been inter- ested in investing. When I was in college I ran a stu- dent investment fund and enjoyed it. I didn’t know anything really about fi- nance, which in some ways was an advantage because we thought more about the companies — their business model, products — than about numbers in a spread- sheet.

As your career progresses, you understand how important thinking about companies is as opposed to just thinking about numbers. In college you take that approach out of naiveté. We thought we had a comparative advantage understanding technology stocks be- cause we were the generation using their products and we were more in the flow of what was popular than someone sitting behind a desk in New York all day.

G&D: You have both an MBA and a JD. What was the rationale for pursuing both and has it helped you being on the fixed income side of investing?

JM: Post-college, I worked at Morgan Stanley in their mergers and acquisitions group and there I learned a lot about finance. That can be a good or a bad thing, as an investor, because as a banker you can end up solv- ing for an outcome as op- posed to taking an unbiased view as to what a company is worth.

I went to business school to round out my banking experience. I enjoyed finance, but I also wanted to think about businesses more holistically, learn how businesses think about sales, product development and management.

I went to law school be- cause I thought law was a very stimulating field. In law school you get to think about big questions and you don’t get that opportunity often in your career. Once you are working full-time, it can often be more difficult than you’d like to step back. I was lucky enough to go to Yale, which is a place that gives you lots of flexibility to follow your interests. It also ended up being very helpful in fixed income, since you deal with contracts and oth- er legal and regulatory is- sues all the time.

G&D: Did you ever think of practicing law?

JM: Never very seriously. I spent a summer practicing law to get a sense for what it was like. I wanted more insight into how the law actually worked.

G&D: You started out doing equity investing and moved to fixed income. Why did you make the move and what do you see as the primary differences?

JM: I was very lucky out of graduate school to work for a fund that had been spun out of a family office with a lot of capital. It was a very small group of us and we could think with a very long horizon and look for good businesses. We did mostly equities, and I really enjoyed it.

But there was something especially stimulating to me about fixed income. On the credit side, whether you are looking at senior loans, or high yield or emerging market debt, you have to do all the analysis you do for equities. You have to under- stand the companies to en- sure you are going to get your coupons and principal. But there is also a much broader analysis you have to do in terms of reading the debt contracts and under- standing covenants; it’s more complicated and in some ways that’s very appealing.

Another difference is that in credit, you can be more certain of the outcome. You buy a bond and you have three or four years left of its life, either it’s going to pay you $100 or it’s going to default. So the market can move against you for six months or a year, but if that bond is money good it’s going to move back pretty quickly because you have a pull to par.

In that way you are reward- ed quickly if your analysis is right. In equities something can trade from 15 times to 10 times and can stay there for years and years. Eventually if you buy at a low enough valuation and you are actually collecting dividends you’ll be fine, and that’s what value investing is, but it can take a really long time to be proven right. Whereas in credit if you are right, generally you see that in a shorter period of time. That’s, I think, an important difference.

G&D: When looking for investments your criteria sound very similar to Buffett-style equity criteria, really looking for a strong business with competitive moats. How do you find that working from the cred- it side? It gives you better principal protection but it seems like an equity way of thinking.

JM: That is something we think about a lot in fixed income. Unless you are doing distressed investing you are paid just for sitting around — whatever the coupon is, 7%, 8%, etc. What you need to ensure is that you are going to be paid back and avoid losses through default.

So thinking about the business model and making sure you are going to be paid in almost any circumstance is really important. In some ways it is similar to the mar- gin of safety concept on the equity side.

There are two ways of looking at the bond market. One is to look at it as a securities market. Securities prices go up and down, and you try to buy a bond today because you think in a month or a quarter it will be worth more. The equivalent on the equity side is technical investing or momentum investing or some- thing like that.

Alternatively you can approach bonds as a market in which you are lending money to companies. What you care about is that the company and the business model are strong enough to pay you interest and principal over the life of the bond. If that is your approach you have to be sure that regard- less of all the things happening to a company that they can’t control, that they can still pay you interest and pay you principal because you understand the drivers of their business well enough. That approach is the equivalent, on the equity side, to a margin of safety or value investing concept. That is the approach we take be- cause we take uncertainty very seriously.

G&D: That’s interesting. Howard Marks spoke to our class last week and talked about how Graham and Dodd emphasized fixed income investing being a negative art in that you don’t always have to pick the right ones but you really need to avoid picking the bad ones.

JM: It’s absolutely the case in fixed income because the historical recovery rates in the high yield market, for instance, are typically forty cents on the dollar. So if you make a mistake you are getting 40 cents back. That’s a lot of coupon you are giving away if you have a default. It is a negative art in that sense. You’ve got to try to make sure the business can withstand everything that’s happening around it in order to minimize your de- fault rate.

G&D: Corporate credit markets are very broad; how do you narrow the opportunity set?

JM: We segment the world by industry at an analyst level and do a first cut to eliminate issues or companies that we aren’t going to spend time on, either be- cause they’re too small or they’re just too illiquid. You can cut the universe down by one third — to one half — depending on exactly what you are looking for. From what’s remaining, we try to do work on most companies. What’s really important in narrowing the opportunity set is that you have a sense of what happens with com-panies during difficult peri- ods. We think one of the best ways to have that sense is to have experienced peo- ple on the team who have seen a number of cycles. It’s fine to think in the abstract about what happens when the economy deteriorates. But when you actually know how companies behave and what management teams have done, what companies try to do with covenants, what happens to cash flows in cyclical industries — having a team that has lived these issues gives you a lot of comfort as you go into a downturn.

G&D: It would be interest- ing to talk about the busi- ness model of an asset man- ager and how you view it versus how some other large asset managers ap- proach it.

JM: There are many sides to that question. How you set up your organization is really important for long- term success and there are lots of decisions you can make that might enhance short term profitability but are the wrong long-term decisions for generating good returns, and ultimately that is what matters.

One decision we made on the business side is to have senior investment professionals, with the goal of minimizing defaults. While you may not make this decision if you are focused on short term profitability, we try to keep sight of what’s really important to success in the business. Here it’s attention to protecting on the down- side and having the experience to know what happens to companies in difficult times.

The other decision we’ve made is to stay focused on corporate credit. Lots of asset managers, for a variety of reasons, start with a focus but then want to get into a lot of different verticals from a diversity of business perspective. So they’ll start in growth equity and then move to value equities, and maybe from value equities move into converts and credit.

I can see why people do that, but we feel we have a competitive edge by doing nothing but credit. We are very aligned with our investors because we can’t do credit badly and then rely on an equity team to per- form well. This focus also generates robust debate, because credit is what people discuss all the time, and real debate is important to the investment process.

Talking about credit all the time might sound boring, I’m sure it does, but that is what makes you good. So a big business model decision has been to stay focused on corporate credit. A third business model decision has been to be global. This requires investment teams in several countries, and again is not something you would do if you were focused on short term profitability. But we think it makes us better investors with a broader opportunity set to be able to invest in European and emerging market credit, not just US credit.

G&D: Muzinich & Co. flies under the radar more than we would expect from a firm with your AUM. Is that a strategic decision or is that just the fact that we come from a non-credit background?

JM: It is a strategic decision. We think what is going to matter over the long term is doing a great job for our investors. It doesn’t

help us to do a great job for our investors by appearing on TV. Our view is that we just want to stay focused on what’s ultimately going to matter over the long run, which is picking good companies at the right valuations.

G&D: Do you find it affects your investment process at all? There are some people who deliberately try to stay off the radar so that it’s easier for them to do deeper due diligence.

JM: Some might keep a low profile because their profile is not one which companies they invest in would like. But we’re generally investors that companies like to have, because of our longer term outlook, so we don’t have a problem with access to management etcetera. For us it’s more just a matter of where we put our focus and what consumes our time every day. Spend- ing time on TV does not help us earn good returns. Time management is one of the most important things in investing and we just want to be focused on what will matter over the long run.

G&D: In terms of focusing on corporate credit, you primarily do high yield, but will you branch into invest- ment grade if you think there is some type of dislo- cation?

JM: The firm is not just high yield; we define it as global corporate credit gen- erally. So we do a fair amount of crossover invest- ing between, for instance, investment grade and high yield because of structural reasons. When you make the transition from invest- ment grade to high yield there are often a lot of forced sellers and inefficien- cies. Over time that’s been an interesting area for us to focus on.

We also invest in senior loans and we have a hedged vehicle which has a lot of flexibility to put on arbitrage trades. We look at the whole credit universe, ex- cept upper tier investment grade, because that is driven by interest rates. We don’t think we can consistently predict what’s going to hap- pen to interest rates, which is a very liquid and efficient market. So we try to be very honest about that with our investors.

We also don’t do a lot of distressed investing. We have people who have done distressed, and we certainly can. But if you are going to do distressed full time, it’s

as much legal analysis as it is credit analysis and that is a different skill set. Again, we want to be focused on what we’re really good at.

G&D: So if one of the names you hold does move into a distressed situation will you work with them on a credit committee?

JM: Yes, if that is the right thing to do for investors, absolutely.

G&D: In terms of portfolio management, how do you think about the number of positions you have and in- dustry concentration? Are you managing to a bench- mark in some instances and not others?

JM: We don’t manage to a benchmark. Certainly some of our investors might be more benchmark oriented than we are; it’s just a reali- ty of the investment world. The way the industry is set up you have investment committees and consultants who use benchmarks so you can’t avoid it to some de- gree.

But we don’t make invest- ment decisions based on a benchmark. For instance, we hardly held any financials going into 2008, even though they were part of the benchmark. We hardly held any telecom going into

2000, and at times we’ve been totally out of indus- tries when we think it’s the right thing. There are peo- ple in the investment world who look at benchmarks, but benchmarks don’t drive our investment decisions.

G&D: What kept you out of financials in 2008?

JM: On financials, it wasn’t a great insight that financials were going to go through all the turmoil they ultimately did. We weren’t totally comfortable with what was happening, but we didn’t make some great call that there was going to be a fi- nancial collapse either.

We were out of financials because we couldn’t evalu- ate them from a credit per- spective. The first rule of credit investing is you don’t invest if you don’t under- stand, and that requires a lot of intellectual honesty.

They were such black box- es. I remember talking to a very senior research analyst, one of the most senior banking analysts on Wall Street, at the end of 2007. I asked him, “Can you really look me in the eye and tell me that you understand the risks broker-dealers are exposed to or is this a black box?” This guy who had made a career of financials, who has been covering fi- nancials for 20 years and writes very long reports on these institutions, said that at the end of the day, it’s a black box. We just didn’t know what exposures they had on their own book and what they had done to hedge out ex- posures. There wasn’t transparency, which you need for credit investing.

G&D: Has that changed since then? Have you guys moved into more financials?

JM: In the case of broker- dealers for instance, we still feel like we really can’t eval- uate the risks to the point where we are comfortable. There are times when you might get paid for that un- certainty. But you really need to be paid a lot. That said, there is a price where taking on this uncertainty can make sense. We will invest in leasing companies where there is actually col- lateral you can understand and it’s much more trans- parent. But that’s just not the case with the broker- dealers.

G&D: Coming back to diversification, how do you think about it in the context of fixed income portfolios?

JM: From the equity side there are pro and con arguments for diversification. And there is certainly an argument to be made for just investing in a handful of companies you know really well, where you really understand what’s going on in the business. On the credit side, because it’s a negative art, and be- cause so much of it is risk control, I think there is a good argument for diversification. If you only have ten names in an equity book and one triples, that’s great.

That makes a lot of sense. In credit you usually buy some- thing at $100 or relatively close to par, unless it is a distressed market, but you are not going to get $300 back; maybe you’ll get slightly above par. So you don’t get the payoff from being concentrated. On the flip side you can get hurt if you hold ten names and something unexpected happens, and one position ends up being worth 40 cents on the dollar. One way to control that risk is diversification and that’s why banks and lending institutions also have diversified books. When I was spending a lot of time on equities I came to dislike the word diversification as an equity analyst. In fixed income I’ve come to appreciate it.

G&D: Do you mind talking a bit about what you do in terms of credit long-short ideas and where you see most opportunities?

JM: Sure, we see lots of opportunities. Generally what we try to do is look for companies that are yielding a similar amount but have very different risk pro- files. Over time yields generally reflect risk profiles so the securities eventually should converge to fair value.

There are two areas where we generally find opportunities. One is intra-capital structure arbitrage. One company might have senior loans and high yield bonds, and let’s say the market has really rallied and they’re trading at about the same levels. But senior loans are floating rate instruments and high yield bonds are fixed rate, and the loans are senior in the capital structure.

With interest rates so low now it’s difficult for them to go much lower. So you should get paid more to own high yield, because it doesn’t have a floating rate feature and it’s lower in capital structure. When credit markets rally it’s of- ten because of technicals in the market, and the same when they sell off. Every- thing will move up together and often the price between these two securities in the capital structure will con- verge substantially. When that happens we can arbitrage the two against each other. We short the bonds, for instance, and go long the loan. You largely offset your cost of carry from shorting the bonds.

Another area where we often find ideas are what we call intra-industry trades. There will be two companies in the same industry, one with a great business model and one we think is a very bad business model, more cyclical maybe or just a different cost structure. Again, in a strong market, bonds often move within the industry in the same way and then when there is pressure on the market, bonds are differentiated. But when everything is moving up the yields get pretty close.

G&D: On the opposite side, when spreads haven’t necessarily converged, when they’ve diverged, how do you go about identifying attractive trades?

JM: Often what we’ve seen happening, and this is partly because the books of broker-dealers are smaller be- cause they are not making markets in the way they used to, is big liquid bond complexes, in periods of stress, will trade off more than less liquid ones, be- cause retail money is moving in and out of the market, and retail focused funds have to sell more liquid bonds to satisfy redemptions.

So we often see artificial pressure being put on big liquid complexes and often these are companies where there is no question that they are not going to default. They have huge equity market capitalizations and we know the business models very well. It’s just that the flows are causing movements in security prices within the markets. So we’ll often see opportunities around flow-based names when the market sells off and we can arbitrage those against names that aren’t selling off as much, or aren’t as flow- based.

G&D: Do you think the rise of high yield ETFs exacerbates that sort of behav- ior?

JM: It exacerbates some of that behavior. ETFs — we could talk for an hour just about this — create their own sets of inefficiencies around the market because they’re rule-based. They operate based on arbitrary rules. Not rules that are based on the value of the underlying company, but rules that say you can only own certain types of issues or certain types of securities. So if there are out- flows then that type of issue or that type of security gets sold, it has nothing to do with the underlying value of the company, it’s just be- cause of some rule being executed. So we spend a lot of time trying to understand those rules and the pressure that those rules put on different securities.

G&D: Based on that liquid- ity aspect, will you typically hold cash bonds or do you consider using credit default swaps (CDS) to gain expo- sure?

JM: We’ll typically hold cash bonds. In our hedge strategy we’ll use CDS, but we typically transact in the cash markets.

G&D: Given the current interest rate environment and the fact that interest rates are going to have to go up from here at some point, how are you thinking about duration?

JM: For the more credit- focused part of the market, duration doesn’t matter too much. The long term correlation of the high yield market to the ten year treasury is zero. It’s actually very slightly negative even. That’s because in a rising rate environment companies are generally doing well, and likely have some pricing power from inflation, so even if rates are moving up, spreads will often com- press at the same time. That’s historically been true, but sometimes it doesn’t happen. But generally it’s not illogical that you would be in a spread compressing environment at the same time that rates are going up. However you may get to a point where spreads can’t compress anymore and rates still rise. Especially when rates are low and the curve is fairly flat, we’ll be on the shorter duration side. However, we don’t have an in-house view of where rates are going.

But we can have a view that there is a lot of uncertainty about rates and we’re not being paid for that uncertainty. Also, in our hedged strategy, we have the flexibility to arbitrage out duration. If you put on a trade going long loans and short the bonds you achieve this.

G&D: What about the duration needs of your in- vestors?

JM: Different investors have different duration needs. For instance, insur- ance companies often match asset and liability duration, whereas endowments sometimes do not. The du- ration needs of our inves- tors can drive whether they invest with us in duration- hedged strategies or not.

G&D: You are also in- volved in opportunities out- side of the U.S., particularly in Europe. Could you ex- plain the opportunity you see there?

JM: The European debt markets are really interest- ing right now. The European high yield market developed after the U.S. high yield mar- ket. The private equity mar- ket there developed after the U.S. private equity mar- ket. On the debt side of things they often take their cue from the U.S. markets.

Several decades ago, small and medium size businesses in the U.S. got a majority of their financing from banks. That’s come down over the last few decades to about 30 percent. In Europe, small and medium size businesses get about 90 percent of their financing from banks. Banks in Europe are under tremendous pressure, they are de-levering, and their banks did not restructure in the way our banks did in 2009.

For a variety of reasons this is putting more pressure on small and medium size busi- nesses than on large busi- nesses. One of the ways banks make money is cross- selling. They don’t make

that much money on the actual loans they make to companies, but on selling foreign exchange services and a variety of other ser- vices to companies they make loans to.

Banks can do more cross- selling to large companies because their businesses are more international, there- fore they need these addi- tional services. So as banks are capital constrained, they’re focusing more and more on large companies. While all companies in Eu- rope are feeling the pinch of the credit crunch, the small to medium size companies are most impacted.

A lot of these businesses are great businesses. We’ve been spending a lot of time for instance in Northern Italy, where there are a lot of well protected niche businesses that have made it through multiple cycles in- cluding 2008 and 2009. So the businesses which remain are often very good. They often have long-term inter- national contracts. But if they want to expand or they have an opportunity to win a new contract, they just can’t get financing anymore.

So through our investment funds we can provide financ- ing to them, which we think is a good risk-reward for

the investors in our funds. We do have to match assets and liabilities because these are private loans. You are not going to get your mon- ey back until the maturity of the loan so you have to make sure your capital is long term. But we see some pretty good opportunities and have been spending a lot of time in Europe.

G&D: What was it that drew you to Italy? Was it the fact that their financial institutions have taken a particular beating or was it some other reason?

JM: We’re looking at all of Europe. In Italy and Spain the banks are in more trouble than other countries. There are a lot of northern Italian business we know from experience are very well run. There are lots of great manufacturing businesses and a great manufacturing culture. We thought that in Italy, because it was one of the powder kegs of Europe, there was a good chance the baby was being thrown out with the bath water. People didn’t want to deal with a company because it had an Italian flag, even if most of its revenue came from outside Italy. Many businesses in Italy were just as solid as businesses in Germany. You still have to be sensitive to the regulatory regime and the bankruptcy regime. But the different bankruptcy regimes always existed, while the price that you paid in 2007 versus 2008 or 2009 really gapped out when you looked at Germa- ny compared Italy. That’s because companies were being dismissed simply be- cause of their Italian flag.

G&D: How do you build that business out, do you set up an origination team on the ground and how time intensive is it?

JM: It took us a year and a tremendous amount of work to set up before we were really comfortable with it. If you are going do it right, you’ve got to put the infrastructure in place and hire a number of people in Italy. Now we’re seeing strong deal flow and a decent number seem to be very good risk-reward opportunities. They are good business models with low debt to EBITDA that need financing and we can be good long term partners because we have a long term view of the world and want to help them grow.

G&D: We noticed that you co-authored an article with Dean Hubbard recently and were curious what motivated you to work on that and how it relates to your investing? And is there a particular area that you think the Fed should be focusing on currently to address excesses?

JM: We co-authored one piece together and Glenn Hubbard is just a terrific guy. It was a privilege to work together. On the first part of the question, how does that overlap with in- vesting? I think investing is about being curious and I think that leads very naturally to writing. Investing is a never-ending stream of interesting questions. You can think about business models, about the world, about what other people are thinking and where there are opportunities. Often, thinking about companies leads to thinking about some broader question, because companies inhabit a world around them.

I also believe it is important to try to contribute to the public debate if you have an idea, even if in just a small way. In terms of the Fed, we have some views in our article about what the Fed can and can’t credibly do. We think it’s difficult given the way the Fed is structured right now to credibly say they’re going to be very good at what’s called “macro prudential regulation,” which is just a fancy word for trying to stop bubbles. We should think about institutional reform rather than lots of these small rules-based reforms around the edges, which don’t fundamentally change the mandate or structure of the Fed.

G&D: Could you briefly talk about a mistake you’ve made, either in investing or in your career, and what you learned from it?

JM: Early in your career it’s easy to be overly focused on numbers, especially if you are coming out of an investment bank or out of business school, and I made this mistake. Numbers are really important and you certainly have to understand valuation, but the most important thing is finding good businesses. I think it’s easy early in your career not to appreciate what really makes a good business. I love reading Buffett’s letters and his discussions about moats around good businesses, but until you interact with enough businesses and understand what a moat actually is, you don’t really appreciate it.

G&D: Any parting words of advice to our readers, and especially to any students interested in careers in investing?

JM: I’ll come back to something I said earlier in the interview, which is to try to be really stimulated by investing and to keep a sense of curiosity. I think that’s what makes the best investors. It allows you to have insights into where there might be opportunities and that’s a very important starting point for investing.

G&D: Thank you very much for your time, Mr. Muzinich.